Tyler Cowen recently responded to some wage stickiness comments by Bryan Caplan and myself:
But if people who work on commission and tips are out of work in large numbers, or if truly flex-wage workers are being laid off, why see wage stickiness as the #1 culprit? (Scott isn’t following through the logical implications of his cyclicality point.) In economies with truly flexible wages, people are forced to retreat into household production in down times and that is perhaps a better parable for America today. No one will hire them, flexibility or not. Plus if workers are irrational by focusing on the nominal rather than the real values, it’s easy enough to trick them by cutting real benefits and working conditions, thereby saving the employer money. Real wage flexibility should be enough to keep them at work, yet it isn’t.
I have 5 comments on this passage.
1. I don’t follow the logic of the last sentence. First of all, nominal wage rigidity may be due to contracts, not money illusion. But even if it is money illusion, Tyler’s argument doesn’t follow. Just because a factory worker with limited skill at math doesn’t understand the distinction between a cut in nominal wages and a cut in real wages, does not mean that he wouldn’t realize if the assembly line sped up from 60 to 80 cars an hour. And if he truly wouldn’t realize this, why hadn’t the car company already sped up the line?
2. Just because aggregate nominal wage stickiness causes aggregate unemployment to rise, doesn’t mean wage flexibility in a single profession can prevent unemployment in that profession from rising during recessions. There is a coordination problem here. Suppose the money supply falls 10%, and all economic agents get in a room and immediately decide to cut all wages and prices by 10%. Will it prevent recession? We can’t be sure, but later I’ll argue that it will. But if they don’t do that, then we will have a recession. In that case most nurses will not lose their jobs even if they refuse to take pay cuts, and many factory workers will lose their jobs even if they take 10% pay cuts. Nominal shocks cause recessions that have very different effects on cyclical and non-cyclical industries. I believe that is a prediction of every important business cycle model.
3. I agree that nominal wage flexibility plays no role in explaining the chronically high unemployment in certain economies. The argument is that nominal rigidity explains why unemployment rises in the face of nominal shocks, and that’s all it explains. I have no idea why Haitian businesses don’t cut wages when there are Haitians who are willing and able to do the same work for less. Perhaps there is some sort of efficiency wage explanation. In any case, the chronically high unemployment that one observes in certain developing countries, or even in some eurozone members, has nothing to do with nominal wage rigidity.
4. I don’t see “wage stickiness as the #1 culprit”. Here is an analogy. Suppose we observe engine failure once a month on jetliners. Each time the plane crashes. What’s the fundamental problem here, bad engines, or gravity? Most people would say bad engines. Now assume that every few years the Fed creates a negative nominal shock. Because nominal wages are sticky, it creates a temporary recession (until wages adjust.) What’s the fundamental problem here, sticky wages or monetary policy? I’d say monetary policy. To me, nominal stickiness is just a part of nature, like gravity. It is not something you’d think about altering with government policies. (BTW, it certainly isn’t the fault of “workers” most of whom don’t even set their nominal wage.) Just as gravity is something airplane engineers must take into account, nominal stickiness is something that the Fed must take into account. Of course there are government policies that increase real wage stickiness (minimum wages, extended IU benefits, etc) and those can make the problem worse. At the risk of making my airliner analogy even more ludicrous, these rigidities are analogous to installing giant magnets on the ground, which try to suck airplanes out of the sky. (Yes, I know that airplanes are aluminum.)
5. Here’s why I can’t shake the idea that nominal wage (and perhaps price) stickiness is the key problem when AD falls. Consider the 1920-21 deflation, which was quite rapid. It was caused by a big drop in the monetary base (I believe around a 17% decline.) Unemployment rose sharply, until wages had adjusted. Now it seems to me that if these two facts are not related, if the rapid deflation (more than 20% depending on the index) did not cause the high unemployment in 1921, then I should just quit economics. It would mean that everything I think I know is wrong–that I have nothing useful to say. (Some people might wish I’d quit.) But let’s assume I and the other 95% of economists who believe deflationary monetary policies increase unemployment are correct. What then? Well then explain this: A few years back Mexico experienced 99.9% deflation almost overnight. Prices plunged far more sharply than they did in the US between 1920-21. And yet there was no sudden spike in the unemployment rate. How could this be? My theory is that Mexico avoided high unemployment during this severe deflation because the government ordered all nominal wage rates to be immediately cut by 99.9%. Prices fell by a roughly similar amount (I don’t know if the government ordered them to fall.) The point is that even severe deflation doesn’t cause additional unemployment if there is no nominal wage stickiness in the system.
Until someone can find a plausible alternative explanation for why America experienced high unemployment in 1921, but Mexico did not during a much more severe deflation during 1993, then I’m sticking with the sticky wage (and price) explanation of why nominal shocks have real effects.
One final point. Once a major deflationary shock creates a severe recession, all sorts of real supply-side factors enter the equation. I’ve already mentioned the cyclical effects of nominal shocks. There is also the decision to raise IU from 26 weeks to 99 weeks—something that never would have happened without the initial nominal shock that created the recession. But once those real factors kick in, the outcome can look very much like a real shock to a casual observer. Don’t underrate the importance of unemployment benefits and other labor market rigidities. The eurozone experienced long periods of near 10% unemployment (for reasons unrelated to nominal wage rigidities), there is no reason that it could not happen here—if we follow similar policies.
If the Fed boosts NGDP sharply, unemployment will fall sharply, Congress will let the extended IU benefits expire, and SRAS will shift right as AD is shifting right. A win-win scenario. Oh, and the budget deficit will automatically get much smaller.